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Public Pensions, Public DisastersBy John Mauldin
This week we will look with fresh eyes at an old problem: US pension funds, both public and private, are under-funded, and the situation is getting worse. And the US taxpayer is going to get to fund the difference. The recent slew of data on pension funds suggests that little is being done to correct the huge and mounting problems I have written about for years. Even the recent market upturns of the past few years have not been as big a help as it should have been. I wrote this over two years ago: "...there is something north of $1 trillion dollars in equity assets in the 123 state pension funds covered in this [Wilshire] study. My back of the napkin analysis shows that pension fund estimates assume that the equity portion of the pension fund assets will grow by 10% or around $100 billion per year. "That means in 7 years and at 10% compounding, they are assuming there will be approximately $1 trillion dollars in growth from the equity portion of their assets. "If the stock market is flat, they will be short $1 trillion in only 7 years, from a "mere" $180 billion shortfall today. If the market grows at 3%, the states will be down $750 billion from their estimates." In the last few years since then, corporate earnings have grown well above the long term trend and the broad stock market has grown over 10% a year. Surely, then, things should better. Sadly, they have not improved. Let's look at some recent data. First, let's look at corporate America and then at Public (state, county and city) pension funds. Companies with underfunded pension plans reported a record shortfall of $353.7 billion in their latest filings with the Pension Benefit Guaranty Corporation (PBGC), Executive Director Bradley Belt told the Senate Finance Committee last week. That is up considerably from the $279 billion reported a year earlier, and over $300 billion from four years ago. The total increase in underfunding last year was $75 billion, or 27%. Below is a chart showing underfunded pension plans.
The 2004 reports, filed with the PBGC by April 15, 2005, were submitted for 1,108 pension plans covering about 15 million workers and retirees. The underfunded plans had $786.8 billion in assets to cover more than $1.14 trillion in liabilities, for an average funded ratio of 69 percent. But it is actually even worse. The reports are required only of companies with more than $50 million in unfunded pension liabilities. Smaller pension plans with smaller problems did not go into that figure. Adding them, as of September 30, 2004, the PBGC estimated that the total shortfall in all insured pension plans exceeded $450 billion. Belt's testimony also contained a detailed analysis of the pension plans of United Airlines. Although the plans have an aggregate funding shortfall of almost $10 billion and an average funded ratio of 41 percent, the company was able to go for years without making any cash contributions to the plans, without paying additional premiums to the PBGC, and without sending underfunding notices to plan participants. All within the rules, you understand. If you are a United employee, you are not happy right now. Hey, It's Only a Few Trillion Here and There OK, let's do a little back of the napkin math. These companies assume about 8-9% forward earnings in their plans. The median plan got 10.8% last year, according to Wilshire. That is quite troubling because if you perform above plan and are in worse shape it means that you are not funding your liabilities. It seems many companies are betting (hoping? gambling?) that another new bull market will return and save their collective pensions schemes. That puts tax-payers at risk, not to mention those who expect to retire on their pensions. Second, let's just look at the roughly $800 billion in assets. Let's look at a typical 60% stock, 40% bond asset allocation mix. Let's generously assume you can make 5% annualized on your 40% bond portfolio allocation in the next ten years. That means to get your 8% (assuming a lower average target) you must get 10% on your stock portfolio. Now, about 2% of that can come from dividends. That means the rest must come from capital appreciation. Hello, Dow 22,000 in 2015. Care to make that bet with me? But pension plan managers are doing precisely that. Earnings over long periods (and ten years is a longer period) grow about GDP plus inflation. Let's generously assume 6% earnings growth. A 22,000 Dow (or a 2500 S&P 500) means we will have to get back to bubble valuations, or P/E ratios into the high 20s for the largest cap stocks. Why? Because if earnings grow at only 6% and the market grows at 10%, P/E multiples have to get much larger. It is Back to the Future. 6% is too low for earnings growth you say? Am I being too pessimistic? Go here. This is Standard and Poor's spread sheet on S&P 500 earnings. Depending in whether you use core, as reported or operating earnings, you get a little more than 6% or a little less than 7% earnings growth over the last ten years. That is a period of time encompassing the greatest bull market in history, a very mild recession, and in which earnings in the last few years have grown to all- time highs as a percentage of GDP. In short, it is hard to find many better ten year earnings periods in the last 100 years. It doesn't get much better, except in extreme cases coming off of serious recessions. Thus, all we can optimistically hope for is a lousy 6-7%, which is in fact a very respectable number. I hope we can do that in the next ten years. Bluntly, since we are at all-time highs in earnings as percentage of GDP, it will be quite difficult to see earnings grow at 6-7%. All this simply means is that unless we get a return to a stock market bubble, it is highly unlikely we get to Dow 22,000 or S&P 2500. That means that those pension plan woes are going to get worse. How much worse? If you buy my case that we are in a secular bear market and that valuations are going to go lower, then it can get a lot worse. Stock market valuations are easily within the highest 20% in terms of the last 100 years or so. When valuations are at today's level, the stock market on average has returned 0% in real (inflation-adjusted) terms. Not 3 or 2 or 1, but a big zero. Assuming 2-3% inflation and a 2% dividend, you get at most 4-5% nominal returns from the stock market over the next ten years, much less than the 8% growth and 2% dividends projected by the pension funds. When combined with lower bonds returns, total portfolio returns are likely to be in the 5% range, significantly less than the 8-9% projected by most funds. And don't forget, we will have at least one recession and perhaps two in the next ten years. With all the other headwinds, it is hard to see the next ten years as an ideal one for outsize earnings growth. Given the above numbers, the pension plans which are the most under-funded could see a shortfall of between $500 billion and $750 billion. Of course, the rest of the plans will have to make up their losses as well. The latest data I could find suggest that there is about $1.5 trillion in defined benefit corporate plans (looking at a graph and not numbers). The PBGC problem funds have about $800 billion, so there is another $700 billion or so. The actual number is irrelevant for the sake of the argument (and it is getting toward my deadline). All total, corporate pension plans may have to make up an almost $ 1.2 trillion shortfall if the market gives only the 5% which history suggest it will at current valuations and earnings levels. That number comes from the current $400 billion dollar shortfall and a 4% earnings shortfall on the portfolios. It could be a few hundred billion here or there, as no one knows exactly what the future will bring. But whatever the number, it is huge. It is especially huge when you think of it in terms of the potential profits of the companies which offer defined benefit plans. Someone is going to have to make up that difference. Most of it will be through reduced corporate profits. This of course makes it harder for the stocks to grow in valuations, which makes the problem of the projected market growth even more problematical. United We Stand Means Tax-payers Will Pay And some of it will be through you and me as we pay taxes to fund the PBGC. We just bought $10 billion of United Airlines pension debt. But United was allowed to survive. Now they can compete without that debt burden against the rest of the old-line carriers who have not yet gone into chapter 11 so they can shed their pension burdens. And you know they are all thinking about it. The tax-payer in me says let United die so we can see the rest of the airlines possibly survive. With less capacity, the airlines will be able to raise prices and maybe even make a profit. Require them to fully fund their pensions so you and I don't have to pay for their pensions. The free market economist in me says let them die so better run companies can take their place. The government should not be in the business of meddling with the markets. Why should tax-payers pick up the tab and then the shareholders and especially the bond-holders get their money? They knew the risks. Let the market sort out the winners and the losers. Of course, the consumer and frequent flyer in me says let them live so my travel costs will stay low. And the kinder, gentler soul in me says let them live so all the employees will have jobs. And the conflicted tax-payer worries about the unemployment benefits and costs. Ah, the internal conflicts of the modern world. There is no free lunch. Someone's ox will be gored, no matter what the decision. Given the reality of future market returns which project to be below trend, it seems that underfunding problems are only going to become worse. And without new rules protecting tax-payers, it seems likely that we tax-payers are going to pick up several hundred billion or far more in PBGC debt. And the bet is that we will not see new rules until the horse is already out of the barn. Business (and political donors) will scream if faster make-up payments are required of pension funds which are in the hole. Employees (and local voters) will scream about the loss of their jobs. The easy thing for politicians to do is hold committee meetings and actually do nothing. There is no easy solution, so Congress will do nothing. Whether or not you like Bush's Social Security plan, you have to give him kudos for at least bringing the subject up. And with SS a relatively easy fix, it is sad we can make no progress. What will we do when the hard questions of Medicare comes up next decade? It is like the old Fram oil filter commercial: "Pay me now or pay me later." Congress is opting for later. Public Pensions, Public Disasters Wilshire associates report that the problem is worse for public pension plans than for corporate plans. The average underfunded plan has a ratio of assets-to- liabilities equal to 78% (averaging across several categories). 84% of state retirement plans are underfunded. Let's go to the US Census Bureau for some details. (http://www.census.gov/govs/www/retire03.html) The latest data is from 2003. There is roughly $2.2 trillion in state, county and city public pension plans. In 2003, there was a net contribution (or funding) of only $13 million over expenses. The cities, counties and states are clearly hoping the market will bail them out, and data suggest that in 2004 the market did indeed help. But not enough to do more than drop a few percent of the public pensions off the underfunded rolls. Texas pension plans, which I assume are typical of all US plans, assume they will get a return of 8.3% (on average) from their investments. They note they have made 9.8% over the last ten years, so if past performance is indicative of future results, projecting 8.3% is safe and conservative. Except that much of that return was from increased multiples on stock market valuations which are unlikely to repeat in the next ten years, and bonds paid a great deal more then they do today. Again, we could see a 3-5% shortfall under the assumptions. At 4%, this would mean a $1 trillion dollar shortfall on total plan assets. But it gets worse. Since Wilshire suggests that plans are underfunded by slightly over 20%, this means that total underfunding is now over $400 billion (with a B) on a $2.2 trillion dollar portfolio. Every year that $400 billion is not funded means that the fund loses the potential gains from that amount. If plan assets are SUPPOSED to be $2.7 trillion to be fully funded, then an 8% average annual shortfall (the assumed rate of return) due to lower stock and bond market returns suggests that the real shortfall in ten years could be well over $1.5 trillion. (That is their future projections are based on assets of $2.7 trillion with 8% annualized returns, but they are starting now with only $2.2 trillion in assets, so not only are their return assumption to high, but they are starting with 20% less assets to compound over that 10 years. They not only have to make up the 20% shortfall but also the 8% return they projected to make from that 20% that is not there now.) Sinkhole! But what if the shortfall is more than $400 billion? From a Business week article entitled "Sinkhole" of last week: "As much as states are throwing into pensions, they may owe even more. Despite a 2004 stock market rise that should narrow some of the gap, pension experts at Barclays Global Investors say that if public plans calculated their obligations using the more conservative math that private funds do, they would not be $278 billion under, but more than $700 billion in the red. 'It's just ruining the financial picture for states and municipalities,' says Matthew H. Scanlan, managing director of Barclays, one of the largest managers of pension-fund investments. 'You're looking at a taxpayer bailout of this pension crisis at some point.' Crisis is the correct word. If the guys at Barclays are close to right on their pension projections, the shortfall in ten years could easily be $2 trillion! Run that number into your local taxes. And each year the underfunding situation remains, the problem gets worse because of compounding of the losses. It is like a negative amortization loan on a depreciating asset. Each year you owe more but have less to pay with. Back to the article: "There's more bad news. One major category of cost isn't disclosed at all: how much retiree health care has been promised to public retirees. No one can estimate how much these promises will add up to, but they're sure to be in the tens of billions, and only some states seem to have put aside reserves for them, according to bond analysts. That's chilling, given how quickly medical costs are rising. After a pitched battle, the Governmental Accounting Standards Board (GASB), the independent accounting standards-setter for state and local governments, has finally begun to require states to disclose these liabilities. Numerous unions and state government representatives objected to the change, says GASB member Cynthia B. Green, 'not because [unions and states] didn't think these were important, but because they thought once the governments did their studies and found what the price tag was, they would be concerned or, if not concerned, staggered.' The requirement will be phased in beginning in late 2006." Figure that into your local and state taxes. Courts have consistently upheld the obligations of municipalities to fund the promised retirement programs. Unlike private pensions which can be cut or simply abandoned, public pensions will have to meet their commitments. Only four states allow for public pension funds to be cut retroactively. That means taxes will have to be raised or services cut to fund increased contributions. There is a local tax and/or service crunch coming to a city near you in the next decade. If French entrepreneurs are voting with their feet to leave France (which is a beautiful place and one of my favorite countries to visit), you think US tax-payers won't move to cities and counties a little farther out with lower taxes and fewer commitments? The attraction of lower tax communities with fewer pension commitments is going to rise. This will drive down property values in high cost cities. Cities will need to raise taxes collected and this will start tax-payer revolts. In that same Business Week article last week, they cited a Michigan school district which has revenues which are capped, but pension contributions are expected to grow from 13% of payroll to over 20% in three years. No new revenues mean that services will have to be cut. Cutting education expenditures is not always popular in local communities. Few school board members get elected on a promise to cut education expenses, teacher salaries and increase classroom size. Major public pension plans paid out "just" $78.5 billion in the year ended September, 2003. By 2004, that had grown to $118 billion. The growth trajectory is only going to increase as the baby boomer generation reaches retirement age. Of course, you can always do what the Democratic led Illinois legislature is trying to do. You can ignore the $80 million dollar contribution needed for this year, spend it on other items and use accounting tricks to say there is no shortfall. In fairness, you can find many Republican groups who do the same thing. Ignoring pension obligations is one area where there is true bi-partisan cooperation. We could go on, and if you want more gruesome details, I suggest you go to the Business Week article at: http://www.businessweek.com/magazine/content/05_24/b3937081.htm My Shadow is Complaining That about wraps it up for this week. I am in La Jolla, meeting with my partners at Altegris Investments while youngest son Trey (11 years old) surfs. His surfing instructor is this cute little teenage blonde. Life is good sometimes. The problems outlined above have the real potential to cause problems for a static investment approach. My personal and professional approach is to look for appropriate alternative investments. If you are an accredited investor (basically $1,000,000 net worth or more -- see web site for complete details) I invite you to go to www.accreditedinvestor.ws and sign up for my free letter on hedge funds. I work closely with Altegris Investments in the US (and my international partners worldwide) to find and offer a variety of alternative investments, hedge funds and commodity funds. To find out more simply click on the link above. (In this regard, I am president of and a registered representative of Millennium Wave Investments, member NASD. See the important disclosures below.) We are also now also servicing European and Canadian clients in Ontario, with plans to expand over the rest of Canada. Next weekend the family is going to Austin. We will be at good friends Gary and Debi Halbert's lake home on Lake Travis. It is an annual event, and maybe my kids' favorite event of the year. The good news is that much of my letter for next Friday is already written, as I started this letter with what was to be a short comment on Europe and it got too long. Thus I will finish it next week. That is all good, as a little R&R is needed, as my shadow is complaining that I am going too fast. It is hard to ignore all the great business opportunities, the need to communicate personally with clients and partners and an increased research and writing load (more about that in future letters, and yes, I have started yet another major writing project) not to mention family and getting into the gym. But it is the summer and life is treating me kind. My back is getting better, I only have one more meeting this afternoon and then I get to go and watch Trey surf. He has the biggest grin. I am not sure whether it is from getting up and riding the waves or from the cute young thing paying attention to an 11 year old. But I need to get that face on the camera. It is Father's Day weekend. All seven kids are coming home, so I fly back tomorrow to have some time with them. It is one of my favorite days of the year, right up there with all the other days I can get my kids under one roof again. Here's to Dads everywhere. I miss mine, so enjoy them while you can. Your 'reminiscing about his
own less-than-sainted dad' analyst, Jun 17, 2005
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